Section 4.4 Using a Credit Card Responsibly
If you are getting excited about a credit card, this section is to help bring you down to reality. Credit cards have the potential to be very dangerous.
Let’s consider a realistic scenario. Suppose Manny gets his first credit card with a $1,000 limit and an interest rate of 25%. He doesn’t not have much in savings and makes just enough to get buy. Excited to have access to $1,000 to spend, Manny buts a Playstation 5 and a game for (after tax) $600. After the grace period and his credit card bill is due, Manny only pays the minimum amount of $25, leaving his balance at 600 - 25 = $575.
Manny checks his credit report via his credit card’s website and finds that his credit score dropped 10 points because he has “high credit utilization.” While disappointed, Manny is still happy he has his Playstation and $425 left that he can use. Before getting his credit card, Manny couldn’t get a lot of things. He decides to start ordering Door Dash and spends $200 is the next billing cycle. When the next bill is due, the interest from his previous month causes his balance to grow to $587. Adding this month’s Door Dash purchases makes his total balance $787. Once again, he makes the minimum payment of $25. So, now he has a balance of 787 - 25 = $762.
His credit score drops even more as his credit utilization ration has grown. Seeing that Manny has approached his credit limit, his bank adjusts his credit limit to $3,000, meaning Manny has 3,000 - 762 = $2,238. Excited with having more spending power, Manny begins purchasing things he’s always wanted but could never afford such as more games for his Playstation, accessories for his car, some rare collectible figurines, etc. He spends another $1,000 this month. The interest on his $762 balance raises it to $778. Adding the new $1,000 brings a total loan balance to $1,778. He pays all he can afford - the $25 minimum payment for a final balance of $1,753.
Manny starts to get worried. His credit rating is declining each month. That $1,753 is a large amount he owes. He determines to get his spending back into shape. He cuts up the credit card, preventing him from using it. He promises himself he will continue to pay off the credit card debt slowly and steadily. The next month, interest has caused his balance to increase to $1,790. Manny can again only afford the minimum payment of $25. So, his next balance is $1,765.
Manny is dismayed that his balance is going up despite now making any more purchases. His credit rating is hurting. Each month, despite making payments, his balance is going up and up. Manny’s anxiety starts going through the roof. He knows he will need to eventually find a better job, but he is worried his credit be a problem. He knows he needs to make larger payments on his credit card, but he doesn’t have room in his budget. Manny feels trapped underneath his credit debt and doesn’t see a way out.
Manny’s situation is far from unusual or contrived.
Subsection 4.4.1 Activity: Is Credit Card Debt Unusual?
Do a brief Internet search for the following:
- Percentage of American’s with credit card debt.
- Percentage of American’s with at least $5,000 in credit card debt.
- Percentage of American’s with at least $10,000 in credit card debt.
- Percentage of American’s with at least $20,000 in credit card debt.
You have two tasks for this activity:
- Report your findings on the above.
- Suppose you are one of the American’s with $10,000 in credit card debt. The average interest rate for credit cards is around 22%. About how much would you pay in just interest in a year?
Subsection 4.4.2 Debrief
I’m hoping you are coming to understand how easy it is to fall into credit card debt. People usually fall into credit card debt for one of two reasons. First is similar to Manny’s issue: overspending. Credit cards make it really easy to purchase items that don’t fit into your budget. Fortunately, this debt is easy to avoid. Just don’t buy the wants you can’t afford. Of course, that is often easier said than done, particularly for those with strong present bias or social bias. The key is to interpret a credit card as a tool that makes purchasing more efficient with money you already have. A credit card should never be seen as a method to get what you can’t afford.
The other common way people fall into credit card debt is a sudden, unexpected bill. From a large medical deductible from a sudden injury to a massive car repair bill, many people put large expenses they don’t have the cash for onto their credit cards to give themselves more time to pay. The easiest way to avoid this situation is to have a solid emergency or rainy-day fund. Remember that you should try to have at least three months (or even sixth months) worth of your monthly needs amount saved up for emergencies. If you find yourself in a situation in which you have a large bill due but no emergency fund to pay for it, there may be some options. With a large medical bill, remember that there is a full year period after a bill is reported as late for you to pay before any negative information can be put on your report. Also, many hospitals will work with you to set up payment plans. For other large bills, you can ask about payment plans. Many businesses are willing to work with you. You may also be able to hold off on accumulating such bills for a while as you save money. For example, if your car breaks down and needs a large repair, it may be possible to use public transportation for a few months as you save money to repair it. (A few months without paying for gas or insurance adds up.)
Subsection 4.4.3 Activity: Helping Manny
Manny’s situation is not uncommon at all. It really only takes a few purchases that you can’t afford to bury yourself under credit card debt. Getting out from credit card debt is not easy, but it is possible. This activity has two tasks.
- First, analyze what went wrong with Manny’s scenario. How should he have behaved with his new credit card?
- Next, come up with three realistic ways Manny could help lower his credit card debt. Try not to use deus-ex-machina examples, like getting his parents to pay his debt or him suddenly finding a much better-paying job. Just as a point of reference, doubling his monthly payment to $50 would still take almost 6 years for manny to pay off the debt and would cause him to pay a total of about $1,500 in interest on top of the $1,800 his purchases actually cost.
Subsection 4.4.4 Debrief
I am hoping that some of your ways to help get Manny out of debt required some sacrifice on Manny’s part. Often, getting out from credit card debt requires you to make some significant changes in your life and your budgeting. It’s never easy. If often requires you to significantly lower what you can spend on wants each month. In extreme cases, you may even need to move into lower-quality housing with cheaper rent payments.
